Dealing with Italian Banks' 'Pre-existing Conditions'

How exceptional are market developments? Much rests on the answer. If these are extraordinary circumstances, then Japanese intervention becomes more likely. Of course, Japanese policymakers have been inclined to intervene before the UK referendum but were seemingly rebuffed by its G7 partners.

In Europe, the designation of "exceptional circumstances" is critical. Such a designation could soften the EU strictures. Italy is on the leading the push in this direction.

Like Japan, Italy suffered from pre-existing conditions. Essentially, by the time the Italian political situation allowed to address the banking system, the EC had closed the door to the sovereign support. Despite the weakness of Italian banks, there was nary a euro injected by the Italian government into its banks. Unsuspected by many, Germany, France, the UK, and the US injected more money into their banking systems than the Italian government.

After its initial proposal were diluted by the EC, Italy launched its privately capitalized Atlas backstop, with the government selling (not giving) guarantees on the safest tranche of troubled assets that were going to be sold. The program was so compromised, and seemingly underfunded that within a couple of months of the launch, it became clear to many, if not most, observers that additional measures were needed.

Italian banks are widely perceived to a weak link. The Brexit shock has hit all links and especially the weak links. The EU only recently introduced new rules (Bank Recovery and Resolution Directive) that prevent taxpayers’ money (state aid) from being used before shareholders and some creditors are bailed-in. Italy wants to claim "exceptional circumstances," which would waive the state-aid ban.

However, this would stigmatize Italy. Instead, the better path would be to solve Italy's problems, not like an island (like you know who), but like in the context the EU. Such a course would entail declaring a state of emergency of sorts. It would allow all governments to assist their banks.

This was, after all, the US approach. All systemically important banks had to accept government funds. There was no stigma. Those that did not need the funds did not lose anything and were able to re-pay after a certain period.

The decision to declare "exceptional circumstances" requires a unanimous vote. This is important because it shows that while there has been a move toward qualified majority voting, there are many areas, in which the UK's veto (or any country's veto) is still important. Remember, individual countries can veto opening and closing new negotiating chapters with candidates (see Turkey) as well as on the accession decision itself.

As distasteful as some may find it, what are the alternatives for the Italian banks? Doing nothing about the zombie banks and uncovered non-performing loans will likely continue to provide a headwind to the economy and postpone the day of reckoning. It could very well morph into a significant financial crisis.

Italy could trigger OMT, which has been approved by the European Court of Justice. The German Constitutional Court ruled that it does not contradict German law. However, the ECB is already buying Italian bonds under its QE operations, and Italy would have to sign up to a loathsome Memorandum of Understanding (MOU) with the EC and ESM, and probably the ECB.

Italian bank shares rose sharply today as investors anticipate some official action shortly. By not addressing their underlying banking problem, Italy particularly vulnerable to another large shock to the system.

The EC is strained. The departure of the UK shrinks its size by 20%, and it loses a seat in the UN Security Council. There was an intricate merger of sorts that will need to be unwound. Europe will be poorer for it. Italy's strategy appears to be finding a sympathetic ear, not just because the EU wants to protect its flanks in light of the UK's decision, but also because without the UK's influence, the EU may become somewhat more statist and more suspicious of market outcomes.

A pushback from the likes of Germany could spur new sales of Italian banks. It could make like more difficult for Italian Prime Minister Renzi. Cameron's replacement will be picked now no later than early September. Labour's Corbyn is also likely to be challenged now that he lost the vote of confidence by such a wider margin among the party's MPs (172-40). Spain's weekend election saw Rajoy's PP expand its legislative base, but Rajoy is finding it as difficult to find a coalition partner as Trump is finding someone of caliber who is willing to run as his Vice President.

Italy could turn into yet another political maelstrom. A referendum will be held in October on Renzi's constitutional reforms, which essentially neuter the Senate. However, despite the Prime Minister's protestations, it seen as a referendum of Renzi himself. If the referendum is not approved, Renzi has threatened promised to resign. His departure would be end his reform attempt and deepen the pessimism and cynicism that seems so pervasive now.

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